NN IP: ECB faces substantial political constraints

NN IP: ECB faces substantial political constraints

Interest Rates ECB
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Willem Verhagen, Senior economist Multi Asset at NN Investment Partners, shares his views on Thursday’s ECB meeting:

The key driver behind ECB policy is essentially the same as it is for most DM central banks (with the notable exception of the BoJ): The central bank feels a strong need to take out additional insurance against the risk of a break out of inflation expectations to the upside. The basic fear here is that a higher and more prolonged inflation spike will cause workers and businesses to start expecting permanently higher inflation going forward.

While this is certainly a non-negligible risk it is important to note that so far market and survey based longer term inflation expectations appear well anchored. What’s more, a key driver of the transition to a high inflation regime in the 1970’s was a power struggle between workers and businesses for their respective shares of the economic pie which led to wage price spiral. Worker bargaining power has declined significantly since then and unlike in the 1970’s central banks are determined to do whatever it takes to keep inflation expectations anchored.

This determination means that central banks will act as if the economy is moving towards a high inflation regime until clearly proven otherwise. The proof in this respect should consist of a clear and broad based decline in inflation momentum. Because there is long lag between monetary policy and its effect on inflation and because growth is already slowing down, this strategy carries a significant risk that central banks will oversteer and push the economy (deeper) into recession.

The dilemma stemming from the combination of upside inflation and downside growth risks is bigger for the ECB than for many other DM central banks because of the still high dependence of the European economy on natural gas imports from Russia. There is a considerable risk that these flows will diminish further or stop completely at some point in the future. If this happens the economy will almost certainly fall into recession while inflation will at least initially spike higher. In this scenario the medium term inflation outlook will become extremely clouded. Additional supply side restrictions and a more prolonged inflation spike imply additional upside inflation risks but demand destruction taken in isolation could lower future inflation pressure.

The need to protect inflation expectations puts a premium on front loading rate hikes. After all, if the inflation genie gets out of the bottle the policy rate will need to rise much further into restrictive territory for much longer. An added consideration for the ECB at the July meeting was that the policy rate was still in negative territory and as such a long way below the neutral zone. The ECB clearly wants to get a lot close to neutral sooner rather than later because of the risk that a recession will force it to pause.

As a result, the ECB reneged on the forward guidance given in June that it would hike by 25 bps in July and hiked by 50 bps instead. Lagarde gave two reasons for this. First of all, upside risks to inflation had increased as inflation once again surprised on the upside and inflation pressures are broadening out. Secondly, the ECB believes that flexible PEPP reinvestments and the newly introduced Transmission Protection Instrument (TPI) will be able to safeguard a smooth transmission of the policy stance to all countries.

Of course reneging on previously given forward guidance comes at a cost: Any future forward guidance will have a low degree of credibility attached to it. At any rate for now the ECB declines to give any forward guidance at all which is probably a sensible strategy in a highly uncertain stagflationary environment. The ECB expects ongoing policy normalisation will be appropriate but it will decide on the pace on a meeting by meeting basis on the basis of the data available at the time. Presumably policy normalisation means the ECB wishes to bring the policy rate towards neutral but the central bank declines to give any hint of where it thinks neutral might be. Combined with the highly uncertain economic environment all this means that markets have no clear anchor for their expectations of future ECB policy moves. This could lead to additional bond market volatility going forward.

In its desire to make a strong pre-emptive strike against the risk of an unmooring of inflation expectations the ECB faces a challenge other DM central banks do not have. EMU is burdened by an insufficient degree of real, financial and certainly fiscal integration. This renders the Euro area highly susceptible to destabilising internal capital flows. If and when this happens borrowers with exactly the same risk characteristics will face different borrowing costs depending on their country of residence. Such financial fragmentation is clearly undesirable.

A monetary tightening cycle has the potential to trigger such destabilising internal capital flows because it could increase the divergence in economic performance across the Euro area. In particular, because of more than a decade of persistent undercooling as well as generally tighter financial conditions equilibrium yields in the periphery are probably well below those in the core. Hence, a monetary policy stance which is neutral for the region on average will be restrictive for the periphery. This could cause investors to have increasing doubts about peripheral sovereign debt sustainability. If investors start to act on those doubts these will become a self-fulfilling prophecy as happened during the sovereign debt crisis of 2010-12.

To short-circuit such detrimental dynamics sovereigns need a liquidity backstop which only the ECB can provide. Other DM central banks can easily do this because they face one single sovereign. However, the ECB faces 19 (soon 20) different sovereigns and any one of those might give into the temptation of fiscal profligacy knowing that the costs of such action will to a large extent be borne by others. As such the design of an ECB liquidity backstop will have to balance the need to confer a degree of safety to sovereign bonds and the need to discipline sovereigns that do not comply with the fiscal rules through higher borrowing costs.

The recent flare up of political uncertainty in Italy is good example that such a disciplining device can be useful from time to time. Back in 2018-19 Italy had a government intent on flouting the fiscal rules but which had to backtrack on its plans due to Italian spread widening. After the resignation of Draghi a snap election is likely which once again may bring an Italian government to power which does not take the EMU rules of the game seriously enough.

Finding the right balance between safety and discipline in the design of a liquidity backstop is clearly a trial and error process in which the ECB took another step through the creation of the TPI. This new instrument is intended to work alongside existing liquidity backstop instruments, i.e. flexible PEPP reinvestments and the OMT. The TPI will be used in case of unwarranted disorderly market dynamics by which the ECB presumably means a self-fulfilling blow out in peripheral spreads which is unrelated to the underlying fundamentals.

A key question in this respect is what the fundamental level of a sovereign spread in a monetary union should be. Presumably this is determined by redenomination and default risk (alongside a liquidity premium) but as these are events with unimaginable consequences it is very difficult for markets to accurately price these risks. Of course this is precisely the reason peripheral spreads are susceptible to bouts self-fulfilling widening.

In this respect and because the ECB wants to minimise the risk of being accused of the monetary financing of high debt sovereigns, the ECB will retain a large degree of discretion in which circumstances the TPI should be activated and what the pace of purchases should be in that case. At any rate the TPI will in principle apply to all EMU countries provided they meet certain eligibility criteria on fiscal and macroeconomic sustainability. In evaluating these criteria the ECB will also take the opinion of other international organisations such as the EC, the ESM and the IMF into account. Also the ECB promises that the TPI will not interfere with the monetary policy stance but remains vague on how it intends to achieve that.

All in all it remains to be seen whether the details of the TPI known so far will be able to calm investors’ nerves. In an ideal world the ECB would announce a credible liquidity backstop with unlimited firing power. If it were able to do that no investor would dream of fighting the ECB and the ECB would not have to buy a single bond as a result. However, in the real world the ECB faces substantial political constraints. As its 23 year history clearly shows these can only be overcome if the pressure to do so becomes high enough. As such the last word on the liquidity backstop may well not have been said yet.